The Withdrawal Economy

Much of the economic debate, these days, centers on the ultimate shape of the current recession-recovery cycle. Will it look like a dash (soft landing), a V, an L, a U or a W? With the Federal Reserve aggressively lowering interest rates and Congress about to vote large tax cuts, we find no reason to disagree with the consensus view of a recovery taking shape in the second half of 2001. But, while the economy may not decline a lot, I expect that a lot of the fun will be gone.

Whatever the results of the alphabet contest about the shape of the recovery, the excesses that have developed over the last half-decade – and the economic and financial expectations they have engendered -- will take longer than a couple of quarters to correct. In my view, those sectors of the economy that most benefited from the bull market froth will continue to exhibit “withdrawal symptoms”, even as the more steady core of the economy may start recovering in a fairly traditional fashion.

With the bursting of the stock market bubble, richer households will feel a negative “wealth effect”, which will curtail their spending. Particularly, many executives in the new economy, who accepted low salaries in exchange for the promise of large capital gains on their company’s stock, are now stuck with Jacques Cousteau options (so called, of course, because they are underwater). If, on the advice of their accountant and often with borrowed money, they exercised some options without selling the stock so acquired, they also face large tax bills on gains that evaporated before being realized. Some of the big-ticket projects may well have to be postponed, if not abandoned.

Low-income households, which hold few stocks but often own their homes, took advantage of the banks’ typical boom-time laxity to build record levels of credit-card debt or to increase their mortgage loans. Servicing these loans, which probably have now been spent, will reduce discretionary spending for a good while, especially in an environment where employment seems less certain.

The large middle-income population, however, probably will not feel much more pain than in past economic slowdowns.

Corporations that sold products or services at or below cost in exchange for shares or options of their venture-capital-financed start-up customers are now insisting on cash, so that a broad segment of the new economy has to cut back advertising and capital spending to more realistic and sustainable levels. Others, like the telecommunication equipment manufacturers, who actually loaned money to their customers to allow them to buy equipment, are now faced with increasingly doubtful receivables and sharply lower orders from cash-strapped customers. Here, too, the froth seems gone for a good while.

Finally, many high-tech companies which, for several years, “managed” reported profits through stock market investments and the extensive use of derivative products on their own shares, will now have to report only their (much lower) profits from operations.

This will be aggravated by the scrutiny now being cast upon suspect accounting practices facilitated by the growing intimacy between corporate managers and investment bankers’ financial analysts. These accounting shenanigans have created the illusion of much greater stability and predictability of earnings trends than can realistically be expected from any business, and also have probably resulted in an artificial (and unsustainable) boost to reported profits. The shares of these companies may experience a protracted basing period while investors’ assumptions of profitability and growth rates re-adjust to reality.

Again, many firms in the old economy, which did not have the imagination or the opportunity to engage in these New Age practices, will not feel the same degree of withdrawal.

To some extent, however, every component of the economy has benefited from the frothiest fringe of the prosperity, and thus all will experience some withdrawal symptoms. The financial and “tech” sectors, while still relatively small in the context of the overall economy, contributed a significant share of the growth in jobs and in economic activity over the last seven years and were largely responsible for the euphoria that loosened purse strings throughout.

One sector where withdrawal symptoms may create the greatest surprise is government. Our legislators’ energies are now entirely focused on how to spend the huge budget surpluses forecast to accumulate over the coming decade. Not only have government discretionary expenditures begun to accelerate but, as Fortune Magazine reports:

· In a matter of weeks, trillion-dollar tax relief has gone from impossible to inevitable.

I suspect that – even without tax cuts – forecasts of future fiscal surpluses would have started coming down over the next couple of years.

Jeff Petry, of The Dismal Scientist, points out that state tax revenues increased by over $100 billion, or 35%, since 1994 despite some $50 billion in permanent and temporary tax cuts.

Personal income taxes account for about one third of total state revenues and have significantly exceeded even the most optimistic estimates, in the last few years.

In fiscal year 2001, for example, the states’ total expenditures were budgeted to increase about 4%. Despite ongoing tax reductions, Petry figures that revenues will grow by almost twice this rate. And, the biggest driver of surplus revenues has been the top tax bracket’s non-wage income -- particularly capital gains. Realized capital gains have increased from $164 billion in 1995 to an estimated $575 billion in 1999 (note: taxes on those generally accrue in the following year).

Not surprisingly, in view of the collapse of Nasdaq, states’ receipts have already weakened materially. ISI (a wonderful and imaginative economic service) calls 16 state-treasurer offices each month to ask how tax receipts are coming in. Their January survey plunged to its lowest level since they started calling in 1996, which is probably why we are beginning to see ominous headlines like:

· State tax revenues drop

· Slowing economy forces governors to trim budgets

Note that many states have built substantial contingency reserves for a possible, cyclical slowdown in revenues. However, the economic boom and recent labor shortages also cut welfare costs by almost 50%, and it is a safe bet that some of these expenditures will reappear in a less buoyant economy. Finally, among the states emerging from the decade-long boom with the thinnest margin of fiscal safety are New York and California, both heavily populated and highly sensitive to the fortunes of the wealth-tech economy. I hope Californians and New Yorkers enjoy their Federal tax cut, because it might soon be offset by higher state taxes…

Unfortunately, even if we do get a federal tax cut, this may be the last largesse we can expect from Washington for a while.

The Congressional Budget Office (CBO) recently projected cumulative budget surpluses of $2.7 trillion over the next decade (excluding social Security, Medicare and the likely tax cuts). However, there is great uncertainty in these estimates. The CBO itself warns that “the estimated surpluses could be off in one direction or the other, by $53 billion in 2001, $120 billion in 2002 and $412 billion in 2006”.

Moreover, the CBO assumes, as it must, that spending caps and freezes on various programs, enacted in 1997, will be adhered to. Robert Reischauer, of the Brookings Institution, believes that “the polar ice cap will melt and flood New York before Congress accepts such starvation diets”. To stay within the spending caps, he points out, Congress would have to cut discretionary spending – programs like defense, Head Start and the FBI – by about 11%, while allowing discretionary spending to merely keep pace with inflation would cut the next decade’s surplus by over $1 billion dollars.

Then, of course, there are the benefits that, after a decade-long bull market in stocks, we have come to take for granted though they are far from assured. Two recent Business Week articles quote Mark Zandi, of Economy.com, who estimates that revenues from taxes on capital gains taxes and exercised stock options almost quadrupled between 1994-95 and 2000 – to almost $160 billion. It is possible that the $118 billion estimate of 2000 taxes on capital gains is low, since it seems to imply that all of 1999’s capital gains were of the long-term category taxed at a 20% rate.

No matter, such tax revenues still represent real money, and thus a potential source of disappointment for the future. Zandi’s estimates seem to indicate that about 25 percent of the $441 billion swing from a $204 billion deficit in 1994 to a $237 billion surplus in 2000 was generated by capital gains and option exercise realizations.

Altogether, several sectors of the economy will be returning to sustainable levels of revenues and income, as the froth associated with the stock market bubble is eliminated. As I said at the outset, this may not cause a recession, but it sure will take a lot of fun out of the economy.

François Sicart

© Tocqueville Asset Management L.P.
February 11, 2001

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